Leverage and Income Statement

Blackwell Company is planning to expand production because of the increased volume of sales. The CFO estimates that the increased capacity will cost $2,000,000. The expansion can be financed either by bonds at an interest rate of 12% or by selling 40,000 shares of common stock at $50 per share. The current income statement (before expansion) is as follows:

Blackwell Company
Income Statement
2006

Sales
$3,000,000

Less: Variable costs (40%)
$1,200,000

Fixed costs
$800,000

Earnings before interest and taxes
$1,000,000

Less: Interest expense
$400,000

Earnings before taxes
$600,000

Less: Taxes (@ 35%)
$210,000

Earnings after taxes
$390,000

Shares
$100,000

Earnings per share
$3.90

Assume that after expansion, sales are expected to increase by $1,500,000. Variable costs will remain at 40% of sales, and fixed costs will increase by $550,000. The tax rate is 35%.
a. Calculate the degree of operating leverage using the following formula:
DOL = S-TVC/S-TVC-FC

b. Calculate the degree of financial leverage using the following formula:
DFL = EBIT/EBIT-I

c. Calculate the degree of combined leverage before expansion using the following formula:
DCL = S-TVC/S-TVC-FC-I

d. Construct the income statement for the two financial plans.

e. Calculate the degree of operating leverage, the degree of financial leverage, and the degree of combined leverage, after expansion, for the two financing plans.

f. Explain which financing plan you favor and the risks involved.

Solution Preview

Please see the attached file for Blackwell.

f. In the two plans, we need to look at the EPS and the risks due to increased leverage. The debt plan has a higher EPS at 4.62 as compared to 4.41 for the equity plan. The interest charges in the debt ...